What are alternative investments?
Alternative mammal, the duck-billed platypus. Photo: Klaus. Source: Wikipedia
When I was growing up, I never felt part of the “in” crowd. Maybe it was because I played different sports in hockey-and-football obsessed Minnesota. Maybe it was because I was a little clumsy on my feet. Or it could be because I would get so excited about some new idea or crazy plan that I had to tell my friends about it or I would just burst – whether they were interested or not! Whatever the reason, I had a hard time fitting in.
Alternative investments are assets that don’t fit in. They’re not stocks, bonds, or cash. They include all kinds of things: collectibles, commodities, angel investing, insurance funds, and so on. They may be related to the traditional asset classes, but they have a different twist. Physical gold is an alternative investment; gold mining stocks are not. Direct ownership of rental properties is an alternative investment; Real Estate Investment Trusts traded on an exchange are not.
Alternatives are often more complex and less liquid than traditional assets. It takes more time and costs more to buy or sell an apartment building or a 200-year old bottle of wine. There aren’t that many buyers and sellers, each asset is distinctive, and there are other issues to consider – custody, insurance, and so on. But because they’re so unique, prices often don’t follow the stock and bond markets. Most institutional investors have been using alternatives for a long time. With the changes in the market, individuals will be seeking them out as well.
There’s no magic to markets. Assets grow in value because they’re connected to the economy. Every asset represents a particular claim on the cash flow generated within the economy. There are really only three types of assets: stocks, bonds, and real estate. Bonds are a senior claim on cash flow; stocks are a residual claim; and real estate comes in between.
Alternatives are derivative instruments, variations on a theme. They may be either a different way to manage the underlying assets, like hedge funds that can go long and short stocks anywhere in the world. They may be a different way to capitalize on household wealth, like old master paintings or fine wine. Asset prices always depend on how much wealth an economy can produce. That’s why these various indices have all moved from “lower left to upper right” over the long term.
Stocks, Gold, Fine Wine, and Bond Indices. Source: Bloomberg. Log scale.
Institutional investors aren’t the same as individuals. Young people who are saving for retirement 20 years out can “set it and forget it.” It doesn’t matter if the market zigs or zags. As long the market is there for them in the end, they’re in good shape. Individuals approaching or in retirement, however, are more like institutions.
Both have ongoing cash flow needs. But if they’re forced to sell something at an inopportune time for upcoming cash requirements, they risk turning temporary price fluctuations into permanent losses. These investors don’t just need to improve their returns – they need to maximize returns with as little variability as possible. To use another metaphor, if we’re driving somewhere, the destination matters, but how rough the road is along the way matters almost as much. Hitting a big pothole in just the wrong way could cause the transmission in the car to fall out – or at least, damage the tires.
Photo: Kenneth Allen. Source: Geograph.ie. CC BY-SA 2.0
Alternatives are a way to reduce a portfolio’s volatility. Investors should be aware of them, but should also be wary. Investments with limited liquidity and not-very-transparent prices that suddenly become trendy – and even essential – are likely to be abused. As bees are drawn to honey, crooks are drawn to money. There are lots and lots of dodgy “alternative” schemes.
One advantage of not fitting in while growing up is I had to think for myself. I learned to never accept conventional wisdom at face value and to read the fine print. Alternatives are necessary for today’s investment environment. Just be sure to kick the tires.
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